To ERE is humanBlog for the Environmental Resource Economics course at IIT Madas

The Copenhagen Summit, in some sense, was the effort to create a renaissance in the field of environmental cooperation at the global level. The past few decades have been characterized by a number of international environmental agreements (IEA’s), including Helsinki and Oslo Protocols on reduction of sulphur in 1985 and 1994, respectively, the Montreal Protocol on chlorofluorocarbons (CFCs) that deplete the ozone layer in 1987 and Kyoto Protocol on greenhouse gas reductions in 1997. These signify, to a large extent, the recognition that environmental problems are not contained with the political borders of any country and is a global problem that requires global solutions.

Environmental laws and regulations can be classified into two major categories. The first represents the policies that are initiated at the national level and aimed at protection of the environment. These affect the export competitiveness and the importability of products – and hence, affect trade. The second class relates to environmental regulations and policies that arise out of the international agreements or arrangements. This post on Course Module 9 would be primarily dealing with interactions among countries – competitive and cooperative – in setting up environmental policy and hence, would focus on the second class.

Growth and Environment

One of the most interesting questions in the field of international environmental concerns is whether environmental protection rises or declines with the economic growth of a country. Income does influence demand for environmental protection and both seem to be positively correlated. Considering this is true in the case of emerging markets like China and India, the primary question that arises is whether developing countries would use lax environmental regulations as a means to attract capital away from the advanced countries.

One of the techniques used in estimating this relationship is the application of the Kuznets curve – popularly known as the Environmental Kuznets Curve. It determines what happens to the environmental quality as income rises in a specific country over time. However, most of the work has been done based on a cross-sectional data set including several countries in the world, and theoretically, it is constructed as indicated in the figure below. However, with the effects of population density and technology left unmodelled, the interpretation of the EKC needs to be undertaken with care. One of the quick policy implications is for governments to concentrate energy on increasing incomes and letting growth clean up the environment through market demand for environmental quality.

EKC

Pollution Havens is a related concept whereby polluting industries are shifted to poor countries with lax environmental regulations. A frequently cited example in this regard is that of the sweatshops in China that use cheap labour and lax standards to export cheap commodities to the rest of the world. Admitting that developing countries are emitting high levels of pollution, would it be in their advantage to attract polluting industries and specialize in pollution-intensive goods. When empirical investigations were conducted, we fail to find any evidence that argues for countries using lax environmental regulations to attract polluting industries. However, we do find that lax regulations attract FDI for polluting industries. Hence, we could at least partially attribute the theory to understanding the movement of capital with regard to polluting industries.

Transboundary Pollution

The fundamental problem in the area of transboundary pollution is the lack of incentives for countries to engage in abatement efforts. There is a tendency for each country to try and free ride on the efforts of other countries. With abatement effort being considered a public good whose benefits are positive externalities on other countries, there is a trend of under-provision visible in the international arena. Particularly, when it comes to non-uniform damages and non-uniform mixing of pollutants that move across political borders, the country impacted the most would take initiatives on abatement and the rest would prefer to absorb the benefits without incurring the costs of abatement.

Transboundary Pollution in Ontario

How is this different from positive externalities associated with firms located in a country? Within the national limits, the government is able to internalize these externalities using taxes and subsidies. The lack of a supranational authority makes the situation harder to control. For example, even in the case of EU, which claims to have a supranational government, members are flexible about what tools they use to attain particular pollution directives. One of the main causes of the Kyoto failure is that it was not enforceable on countries by a governing authority. It relied on the aspirations of the national governments to integrate Kyoto provisions into their laws and policies.

International Environmental Agreements

The only solution to the pollution problem in the international arena is that of voluntary international environmental agreements. They need to be enforced in order to safeguard the global commons from free riders and over-exploitation. With victims having no “right” to compensation (thanks to Coase?), agreements need to recognize spillover effects and operate in a manner that befits Pareto optimality. Hence, the idea is not to check if side payments can be made (like in the case of Kaldor payments or Coast theorem), but to see what incentives would induce these side payments to be made in actuality – decisions regarding which countries should make what payments dominate the work done in these agreements.

For an environmental agreement to be self-inforcing, two criteria need to be satisfied: there should be no incentive to deviate from the agreed conditions, and the net benefits of every country’s emission reductions should be in favour of climate protection. Thus, the incentive scheme needs to be put in place so that no country has any incentive to move away from the agreement voluntarily – sanctions would be in order in the case of breaching. Theory suggests that such self-enforcement coalitions are likely to be small in size, as greater the number of agents involved, the harder it is to find an agreement that would make someone better off without making someone else worse off. Even with the use of side payments, there is no specific increase seen in the size of the coalition. But, the single most effective solution is the self-enforcement – a system of checks and balances among the agreed parties, for the agreement to work inspite of the lack of a policing organization.

Copenhagen Summit - Illustration of an IEA

How do we put in place such a system of checks and balances? Theory and policy circles suggest two ways: side payments and linkages. One way is to sanction country A if it acts in a way that breaches the net benefits of country B from the agreement. If some countries commit themselves to cooperate, while the remaining countries act independently and in pure self-interest, it appears to be possible to achieve a Pareto improvement if the non-signatory countries reduce their emissions, in exchange for transfers from the countries which sign an agreement.

Nevertheless, most theorists argue that a simpler technique would be to use the behaviour modelling embedded in non-cooperative game theory. Simply put, linking environmental issues with other games of trade and human rights would lead to possible outcomes that would add value by bringing in hesitant partners to join the coalition. Every agreement has a post-contractual risk, with countries failing to comply with the proviso(s) of the agreement. However, with repeated games involving more than the environmental issue, countries could use tit-for-tat strategies and adopt a cooperative equilibrium at the final stage. (Unrelated Punishing)

The primary constraints as to why these theoretical games aren’t translated perfectly into reality are the institutions governing the environmental concerns in each country as well the international institutions involved in the policy-making process. The multitude of organizations, with varied interests, makes it harder for a consensus to emerge on relevant issues.

Institutional Set-up at the International Level

Game Theoretic Approaches

The impact of a single country on the global pollution level is quite small, but the abatement costs are high. Hence, each agent unilaterally an incentive to defect from competition. The incentive structure is very similar to that of a Prisoner’s Dilemma and indicates that the dominant strategy for the country is to defect in terms of abatement efforts. With no supranational authority to monitor and enforce cooperative behaviour, games are the easiest way to induce cooperation.

Barrett proposed a game that has a two-period structure. At time t=0, countries decide whether or not to join a coalition on environmental cooperation. The coalition and the remaining countries choose emission levels non-cooperatively. The coalition would be stable if none of the parties have an incentive to leave the coalition and none of the countries outside want to enter into it. But this model indicates that the cooperation possible makes the size of the coalition very small. Using fairness preferences for international negotiations can be motivated by political economy arguments, there are implications of equity preferences for international cooperation in reducing global pollutant. Relative payoffs, more than absolute, then enter the consideration matrix of the agents and induce cooperative behaviour if they have a preference to be on par with their peer countries. There is a possibility of even completing the grand coalition.

A political economy model at the national level

Using a Partial equilibrium model of a representative import-competing oligopolistic industry, Hillman and Ursprung (1988) argue that environmentalists (greens) tend to side with the protectionists in an economy. Providing the example of policy pronouncements of two competing candidates, introducing the environmental interests as the third group, they side with the protectionist group. A simple illustration of their logic is presented in the form of an algorithm below.

4.01 Pigovian Taxes are set in such a way that it is more cost efficient for the firm to reduce pollution than to pay the taxes (taxes are set higher than the Marginal Social Cost)

4.02 Tax rate (t) is fixed at the point where MB=MC, which is the optimal level

4.03 Internalizing the Marginal Social Cost in decision making, leading a reduction in output Marginal Benefit equals the Private Costs plus the Social Costs

4.04 Not necessary to compensate victims

4.05 Equality of Coase theorem and Pigovian Solutions. Problems in applications of Coase theorem in allocation of public bads.

4.06 In controlling emissions from several polluters whose emissions all contribute to damage in the same way, equimarginal principle requires that MC of cost control be equalized across firms to achieve an emission reduction at the lowest cost possible.

4.07 Inability to measure MSC (Marginal Social Cost) leading to distortion

4.08 Information Asymmetry leads to the provision of wrong incentives to industry making Pigovian taxes inefficient in some scenarios. (Weitzman , 1974)

Part 5. Ambient Charges

Ambient standards used around industrial units and hence are a very popular instrument

5.01 Ambient charges are an attempt to overcome the asymmetry of information which includes mainly the moral hazards and inability to perfectly monitor the emission from each producer. Ambient charges is a system where in the charges are based on the overall ambient concentration of a pollutant in a region. Ambient Charges consists of two parts;

5.02 A per unit charge or subsidy based on the deviation from the ambient standard.
A lump sum penalty for not achieving the standard (independent of the deviation)

5.03 The liability of each polluter in an ambient charge system depends on the aggregate emissions from the entire group of polluters. Since each producer has to pay the full marginal damage of the total level of ambient pollution, he has no incentive to free ride on the other’s actions .The system is not made for budget balancing and therefore allows for this. A disadvantage of Ambient Charges is the amount of information needed to set the appropriate levels of tax/subsidy is vast (like pollutant leeching, runoff, etc.) and is therefore more difficult to implement and monitor.

Part 6. Product Charges

6.01 Product Charges is an indirect attempt to influence behavior by putting a charge directly on the product or input perceived to cause the problem. It gives attention to environmental cost at each at product cycle; production, use, and disposal. It has been criticized for lack of impact on producer behavior because of relatively low levels of product chargesPart 7. Subsidies

Subsidy Break-up for Renewables vs Non-Renewables

7.01 Same MC principle applies as Pigouvian taxes. Same effect in the short run, reducing output of firms by offering a lump-sum subsidy based compensation for reduced output. However taxes preferred in the long run as they are less distortionary, by virtue of subsidies incentivizing market entry in the long run. Subsidies are used for modeling positive externality based interventions

7.02 HSW explores the relationship between environmental subsidies, the diffusion of a clean technology, and the degree of product differentiation in an imperfectly competitive market.
7.03 The subsidy succeeds in reducing environmental damage only when the substitution effect (the reduction in pollution associated with the clean technology) exceeds the output effect (the extent that the subsidy increases output). The model further adds product differentiation and diffusion dynamics.
7.04 When the substitution effect dominates, environmental damage decreases monotonically during the diffusion process. The extent of technology diffusion (the degree to which clean technology replaces dirty) is decreasing in the degree of product differentiation.

7.05 Further, as products become closer substitutes, it is more likely that the subsidy will reduce environmental damage. Finally, the subsidy for clean technology will spill over to the remaining dirty producers, increasing their profit as well. In a free-entry equilibrium, the subsidy decreases pollution when product differentiation is low compared to the relative pollution intensity of the clean technology.Part 8. Liability Rules
8.01 Liability rules are set so that the producer pays a bond up-front and is reimbursed if no environmental harm occurs, or he pays a compliance fee after the harm has been done. It is aimed at reducing shirking on environmental pollution control by raising expected cost of misbehavior.

8.02 Random Penalty Mechanism
8.03 If total ambient concentration exceeds a standard, regulator selects at least one producer at random and fines him. Regulator redistributes the portion of the fine minus the damages to the society to the other producers. Less information is needed to implement compared to taxes, subsidies. It is budget balanced, and does not require additional revenue beyond the welfare gain generated by abatement, but will work only if the firms were risk averse

8.04 Deposit-refund system:
8.05 The purchasers of potentially polluting products pay a surcharge, which is refunded to them when they return the product or container to an approved centre for recycling or proper disposal. It is cost-effective and efficient, as less administrative role is neededPart 9. Quantity Rationing

Efficiency of Permits

9.01 Tradable permits are a cost-efficient, market-driven approach to reducing greenhouse gas emissions. A government must start by deciding how many tons of a particular gas may be emitted each year. It then divides this quantity up into a number of tradable emissions entitlements – measured, perhaps, in CO2-equivalent tons – and allocates them to individual firms. This gives each firm a quota of greenhouse gases that it can emit over a specified interval of time. Then the market takes over.

9.02 Those polluters that can reduce their emissions relatively cheaply may find it profitable to do so and to sell their emissions permits to other firms. Those that find it expensive to cut emissions may find it attractive to buy extra permits. Trading would continue until all profitable trading opportunities had been exhausted.

9.03 Permits would ensure that emissions do not exceed a given level. They are not as good as carbon taxes, however, at guaranteeing that the costs of abatement will be neither too large nor too small. So, in choosing between the two main market-oriented approaches of tradable entitlements and carbon taxes, a government must decide whether it is more important to be certain of the quantity of reduced emissions or of the costs involved.

9.04 Tradable permits are already being used to address several other environmental problems. For example, the US regulates chlorofluorocarbons (CFCs) with tradable emissions entitlements, and it is introducing a similar system to limit emissions of pollutants that cause acid rain. The 1987 Montreal Protocol on Substances that Deplete the Ozone Layer also includes provisions for the international trading of emissions permits, although no such trades have yet taken place.

9.05 To be successful, a permit scheme would have to be carefully designed. If the rules governing trading are complex, or if the market for permits consists of only a few players, trading may not be efficient. This will also be true if trading involves substantial transaction costs. On the other hand, even an inefficient permits system may be a more cost-efficient way to reduce emissions than using most forms of regulatory control. If implemented internationally, tradable permits could lead to resource transfers from rich countries to poor ones. International trading could take place between governments as well as between firms. But before trading could begin, governments would have to agree on how to make the initial allocation of permits.

PCE for CO2 around the world

9.06 One proposal calls for allocating entitlements on an equal per-capita basis. Such an allocation would guarantee resource transfers from the North to the South because, having fewer greenhouse gas emissions per capita than do industrialized ones, developing countries would be net sellers of permits, while rich countries would be net buyers. However, it is highly unlikely that such an allocation would be acceptable to the rich countries. They would probably prefer to have no agreement at all than to make such large transfers.

9.07 To win broad acceptance, an international scheme for tradable permits could not allocate quotas on a simple per-capita basis. The problem is that developed countries have high per-capita emissions, the developing countries have low per-capita emissions, and the former Communist countries are somewhere in between.

9.08 An allocation based on population would be attractive to developing countries, but probably unacceptable to industrial countries because it would require them to make huge transfers to poor countries (assuming that the agreed goal was to reduce global emissions on a large scale). Allocating entitlements according to a slightly more complex formula could reduce these transfers and ensure that every party to the agreement is better off than it would be without the agreement.

9.09 Agreement would be far more likely if the entitlements were initially allocated according to a formula that reflected the different circumstances of these country groups. For example, the developed countries could receive somewhat fewer permits than would be required for current emissions levels, and the poor countries a slight surplus, with the total quantity of entitlements being somewhat below current global emission levels. One study estimates that such an allocation would lower resource transfers to a fraction of current overseas development assistance.

9.10 International tradable permits could be effective even if implemented on a small scale. Economists analyses schemes for emissions permits have usually focused on international agreements for making large-scale reductions in global greenhouse gas emissions. But trading may also be effective in more limited circumstances. For example, a country facing high abatement costs may meet its own national target for emissions reduction by providing incentives for other countries with low abatement costs to undertake abatement on its behalf. Such bilateral agreements (known as “offsets”) may involve relatively high transactions costs, but their small scale may make them easier to negotiate and implement, at least in the short run.

9.11 From a narrow economic perspective, individual countries do not have a strong incentive to reduce their net greenhouse gas emissions unilaterally. Few countries emit more than 1-2% of mankind’s current fossil fuel emissions of carbon dioxide (CO2). So if a country reduced its emissions, it would receive some benefit in the form of a small reduction in global climate change, but that benefit would be only a tiny fraction of the world-wide benefit. As a result, individual countries have very little economic incentive for incurring the costs of abating emissions or of enhancing forests or other “carbon sinks”.

9.12 To be truly effective, climate policies will have to be international. The industrial countries account for about one-half of mankind’s current CO2 emissions. However, even if all the developed countries work together to cut their emissions, they would have only a limited impact on future climate change because emissions are expected to increase rapidly in the developing countries. It must be remembered that, while the industrialized countries are largely responsible for the historical build-up of atmospheric concentrations, new policies can only impact current and future emissions.

9.13 Resource transfers will be required to make an internationally coordinated policy attractive to developing countries. Developing countries may be relatively more vulnerable to climate change than are industrialized countries. However, the total benefit they would receive from policies to reduce climate change damages is likely to be smaller than the benefit realized by industrial countries, since the latter have larger economies (this analysis considers only market goods and services).

9.14 Resources will therefore have to be transferred to developing countries to make it attractive for them to incur the costs of substantially reducing greenhouse gas emissions and enhancing carbon sinks.

9.15 Precedents for such transfers exist. For example, under the amended Montreal Protocol industrialized countries compensate developing countries for the “incremental costs” of substituting new chemicals for CFCs. In the case of climate change, rich countries would find transfers economically attractive because the total cost of abatement can be reduced if the abatement burden is distributed widely. While the UN Convention on Climate Change calls for such transfers, agreeing on their magnitude and distribution will not be easy.

9.16 Free rider incentives will be hard to overcome. The problem is that any country that decides not to participate in the global effort to reduce emissions saves substantially on abatement costs. At the same time, because this country’s emissions are small relative to the total, it would suffer only a minute loss in benefit as a consequence of its own decision not to participate. So this country would be better off economically if it did not participate.

9.17 It will be harder to reduce emissions of carbon dioxide than it has been to reduce emissions of gases that destroy the ozone layer. While it is true that the Montreal Protocol successfully harnessed international cooperation to phase out CFCs, climate change is a very different environmental problem. Reducing CFCs will be relatively cheap, and the economically measurable benefits quite high – largely because ozone depletion causes cancer, which people are willing to pay a lot to avoid. This gave countries strong unilateral incentives to agree to phasing out CFCs. Such is not the case with climate change.

CDM at work

Part 10. Evaluative Criteria

10.01 Effectiveness
10.02 Effectiveness of a system depends on the success in achieving the regulator’s objective which is context specific. If risks associated with small increases in emissions are high, then practical strategy is to use permits (quantity rationing). If the objective is to maintain more certainty over the costs of pollution, emission charges should be used. (price rationing). The debates over effects are based on theory, no incentive systems have been used to make detailed statements on their use.10.03 Efficiency

(a) The aim of efficiency is to achieve regulator’s objectives at the lowest possible cost. Emission charges require constant monitoring, administrative capacity to use the data to set appropriate charges. On the other hand, tradable permit systems ask for a need to establish rules and organization rules of the permit market, monitoring trades between producers and to check if the producers selling permits have reduced their emissions appropriately.

10.04 Equity

(b) Economic incentives can influence the distribution of costs and benefits among the members of society. Regulators can identify the winners who capture the benefits of cleaner environment and the losers who bear the financial cost of burden. Equity stresses on the need for a polluter pays principle, in the case of permits it is granting them the right to pollute. There is a need to also look at the feasibility of firm operating in the markets ( if the cost is too high, factories can relocate) – promotion of jobs, economic growth is important.

10.05 Flexibility to achieve objectives

10.06 A useful economic incentive system should adapt to the changes in markets, technology, and knowledge, social, political and environmental conditions. Fixed rates of charges can be problematic (for e.g.: when inflation rate is high). Tradable permits allows for more flexibility as the price for the permits are set by transactions among producers in the market

Part 11. Practical Conditions for the use of Economic incentives

11.01 Informational base and administrative capacity
• Information is needed on the cost and benefits of alternative incentive systems and recognition of winners and losers. Information needs to be collected, stored and disseminated to provide an adequate knowledge base to implement an economic incentive scheme. There is need to specify the chain of authority, the range and assignment of jurisdiction and the legal standing of the affected parties. In the case of the regulators, they need staff and funding to effectively implement, monitor and enforce the system. Regulators, therefore combine the efficiency gains of economic incentives with the strict standards of command and control to promote pollution control

11.02 Legal Structure
• Legal system is needed to define property rights clearly, provide legal authority to issue incentives and specify who has legal standing and jurisdiction. It is more problematic when dealing common property or centralized property systems

11.03 Competitive Markets
• Economic incentives are more efficient in a competitive environment. They are more advantageous, relative to direct regulations, in markets with many buyers and sellers

11.04 Political Feasibility
• Something that makes economic rationale may not be politically feasible (like random penalty scheme where a well-behaved producer can be penalized due to the shirking of the others). Governments and institutions should also keep in mind jobs and economic growth as these have a political dimension

Part 12. Regulations

Regulation - Pareto Superior but not Pareto Optimal

Part 13. Political economy theory of regulation is based on two theories; 1)Public Interest Theory: purpose of regulation is to protect public interest (Normative), 2) Interest Group Theory: purpose of regulation as promoting the narrow interests of particular groups in society, like individual industries (Positive) and it involves rent seeking. The reasons for regulation includes; imperfect competition, imperfect information, and the need to control the provision of public goods and bads.

Part 14. The political economy of regulation deals with three main institutions that are imperative for regulation. The institutions are;• Legislature: Makes the new laws, define role of regulators
• Judiciary: Tempering the regulator’s actions
• Regulators: Detailed Implementation of the legislature’s laws

14.02 Basic Regulatory Instruments

• Command and Control
(i) It is the dominant method for pollution control and regulation, and can be compared to the centrally planned economies. The regulator here specifies the individual steps the individual polluter must take. There is a restricted choice for polluter as to what means to achieve target and there is no means to ensure equi-marginal efficiency.
(ii) Problems with command and control model include; information costs are high, reduced incentives for innovation. The Polluter only pays for pollution control, not the residual damages from pollution
(iii) Economic Incentives

14.03 Complications for environmental regulation

• Space and Time
• Ambient levels of pollution cause more damage, but emission control do not take this into account since they are harder to measure. Space is a major factor for pollution like urban photochemical smog. Time is also important, like evening and night emissions are less dangerous than morning emissions, also seasonal variations

• Effiency vs. Cost Effectiveness
(i) Efficiency might not be always attainable because of the presence of imperfect information. If Efficiency is practically unattainable, next best solution is to establish targets and regulate polluters in such a way as to achieve the pollution target best way possible. A compromise that sacrifices efficiency in pollution control so that cost-effectiveness can be achieved, which is the second best solution.
14.04 Basic Debate
• The basic debate is over whether to go for a Command-and-Control approach or a. Economic Incentives approach. Economic Incentives make more economic sense, but the former is more prevalent. Another important debate is over the public sources of pollution and the accountability over the control of pollution when it comes from a public source.

Economic Value expresses the degree to which a good or service satisfies individual preferences. These preferences can be expressed in terms of utility, an unobservable ranking of preferences, or a less theoretically appealing, but more practical in money terms.

In neoclassical economics, the value of an object or service is often seen as nothing but the price it would bring in an open and competitive market. This is determined primarily by the demand for the object relative to supply.

In classical economics, the value of an object or condition is the amount of discomfort/labor saved through the consumption or use of an object or condition (Labor Theory of Value). Though exchange value is recognized, economic value is not dependent on the existence of a market and price and value are not seen as equal.Thus, economic value can be measured by the amount of money an individual is willing to pay for a good or service or the amount of money an individual is willing to accept as a compensation for forgoing the good or service.

Willingness to pay (WTP) and willingness to accept (WTA) are measures that can be revealed in exchange. Many goods and services are exchanged on a market, which automatically reveals their value.

The market, however, is capable of revealing only one component of the total economic value. This component, known as direct use value, refers to WTP or WTA for only an actual use of the good or service. The direct use component tends to dominate the total value of most ordinary (non environmental) goods such as books purchased to be read, food bought to be eaten, or cars acquired for transportation.

Values derived from EcosystemSource:www.ecosystemvalue.net

For some natural resources, their value is almost exclusively related to their direct use. The primary example of such a natural resource is crude oil. We are willing to pay for it only as much as the energy it creates is worth to us. Many other natural resources are also highly valued for their direct use, although, direct use may be only one of several components that contribute to their overall worth. For example, lakes, oceans and rivers can be used for swimming, fishing or enjoying water sports; forest are sources of timber, mushrooms, berries, herbs, as well as recreational opportunities; wetlands provide opportunities for bird watching.

Many goods and services, especially environmental ones, are valued for reasons not related to a direct use. However, no consensus exists as to what set of categories is truly exclusive and exhaustive in capturing the remaining elements of the total value. The discussion that follows presents these components of value and their relationship to each other (see the table) in a manner that represents the interpretation most commonly agreed upon by environmental economists.

Types of Values

Economists classify ecosystem values into several types. The two main categories are use values and non-use, or “passive use” values. Whereas use values are based on actual use of the environment, non-use values are values that are not associated with actual use, or even an option to use, an ecosystem or its services.

Types of Value Source: FAO

Thus, use value is defined as the value derived from the actual use of a good or service, such as hunting, fishing, birdwatching, or hiking. Use values may also include indirect uses. For example, an Himalayan wilderness area provides direct use values to the people who visit the area. Other people might enjoy watching a television show about the area and its wildlife, thus receiving indirect use values. People may also receive indirect use values from an input that helps to produce something else that people use directly. For example, the lower organisms on the aquatic food chain provide indirect use values to recreational anglers who catch the fish that eat them.

Direct Use-Values

Consumption use value refers to “extractive” activities, whose object is a precise resource “consumable” in the primary manner (e.g. through hunting, picking and gathering wild fruits) or in the secondary manner entering other goods ( natural substances present in some medicines; the ivory of elephants’ tusks)as a productive factor.

Non-consumption use values refer to all those activities that exploit the resource for recreative and amusing purposes, without its material consumption. A walking tour in the mountains and the bird watching are some examples of these activities which do not cause any damage to the resource, obviously excluding episodes of congestion.

Option value

Option Value is the value that people place on having the option to enjoy something in the future, although they may not currently use it. Thus, it is a type of use value. For example, a person may hope to visit the Himalayan wilderness area sometime in the future, and thus would be willing to pay something to preserve the area in order to maintain that option.

In-direct Use Value

Incidental value means a value derived from passive utilization of a resource, nonconsumption, that an individual can experience in a very occasional way without the necessity to buy additional goods. You may think of an individual who lives in the area of a natural parks and sees a deep from the window of his house or going to work. (Freeman,1984).

The vicarious use value can be distinguished on the basis of the features of media used to create It. If an individuals enjoys the resource through pictures (or taped videocassettes) taken by himself, the use value can be analysed in the relationships between the resource and the input request of photos and videos production. On the contrary , if the resource is used through the vision of T.V. programs or the reading of magazines, the relationship between the resource and the information is complex: it can occur that the information request increases as a consequence of an environmental disaster so to stay in the increasing vicarious use value paradox corresponding to a damage caused to the resource.

Non-Use Values

Non-use values, also referred to as “passive use” values, are values that are not associated with actual use, or even the option to use a good or service.

Bequest value is the value that people place on knowing that future generations will have the option to enjoy something. Thus, bequest value is measured by peoples’ willingness to pay to preserve the natural environment for future generations. For example, a person may be willing to pay to protect the Himalayan wilderness area so that future generations will have the opportunity to enjoy it.

Existence value is the non-use value that people place on simply knowing that something exists, even if they will never see it or use it. For example, a person might be willing to pay to protect the Himalayan wilderness area, even though he or she never expects or even wants to go there, but simply because he or she values the fact that it exists.

Total Economic Value, Sustainable Development & Conservation

The Fine Balance

The total economic value of an environmental resource may assume two connotations: if sustainable use benefits are prevailing that would be a policy cue for sustainable development; if non-use benefits top, then the preference would be conservation.

A market failure occurs when the market does not allocate scarce resources to generate maximum social welfare. A wedge, so as to speak, exists between what a private person does given market prices and what society wants him or her to do to protect the environment. Such a wedge implies wastefulness or economic inefficiency, resources can be reallocated to make at least one person better off without making anyone else worse off.

This module looks at five different cases of market failure, namely: externalities, non-exclusion, non-rival consumption, non-convexities, and asymmetric information. We will then focus on how markets can be expanded to include non-market goods. This draws from the seminal work of Ronald Coase (1960) who argued that government intervention in the form of emission standards, fines, taxes, subsidies, bans and suchlike were unnecessary if transaction costs are zero, i.e. if we remove any institutional constraints that prohibit defining property rights.

Efficient Market Hypothesis

Lodyard (1987) notes that “the best way to understand market failure is to first understand market success.” The First Fundamental Theorem of welfare economics maintains that a competitive equilibrium is always Pareto Efficient, i.e. no one can be made better off by reallocating resources without making someone else worse off. The following are the conditions that must exist for an efficient, competitive market equilibrium:

A complete set of property rights must exist so that buyers and sellers can exchange assets freely for all potential transactions and contingencies.

Transactions costs are zero so charging prices does not consume resources.

Furthermore, for property rights to be considered well defined (condition 1 from above) they must exhibit the following characteristics:

a) Comprehensively assigned: All assets or resources must either be privately or collectively owned, and all entitlements must be known and enforced effectively.

b) Exclusive: All benefits and costs from the use of a resource should accrue to the owner, and only to the owner, either directly or by sale to others.

c) Transferable: All property rights must be transferable from one owner to another in a voluntary exchange.

d) Secure: Property rights must be secure from involuntary seizure or encroachment by other people, firms, or the government.

Externalities

Following from Coase’s diagnosis of incomplete markets leading to market failure, Kenneth Arrow (1969) defines market failure as “a situation in which a private economy lacks the incentives to create a potential market in some good, and the non existence of this good results in the loss of efficiency.” This means quite simply, one person imposes a cost or bestows a benefit upon another with neither compensation nor consent.

Non-exclusion and the Commons

A good is said to be excludable when it’s possible to use prices to ration individual use. And it is said to be rival when it is possible to ration the use of the said good. A “common property resource” refers to a property rights regime that allows some collective body to devise schemes to exclude others, thereby allowing the capture of future benefit streams and “open-access” implies there is no ownership in the sense that “everybody’s property is nobody’s property”. A fishing ground would be an example of the latter. Economic theory tells us that for a self interested fisherman fishing on an open access fishery, the dominant strategy is to not cooperate and this outcome is a Nash Equilibrium. A Nash equilibrium exists when neither player has an incentive to unilaterally change his strategy.

Elinor Ostrom and others have documented several real world examples of actual common property resources in which players achieve a cooperative outcome. There groups establish self-governing common property regimes without strict private property rules or government intervention. Research suggests that successful self-coordination of actual common property rights regimes seem to depend, among other things, on information and transaction costs of achieving a credible commitment to the collective, active rules to self-monitor and sanction violators, and the presence of boundary rules that define who can appropriate resources from the commons.

Non-rivalry and Public Goods

Pure Public Goods are by definition, non-rival. That is, one person’s consumption does not reduce another person’s consumption. In addition, since everyone benefits from the services provided by a pure public good and no one can be excluded from these benefits, there is a general concern that people will “free ride”. A free-rider is someone who conceals his or her preferences for the good and enjoys the benefits without paying for them. Using some simple mathematical models it is possible to show that in the case of a public good such as environmental protection, a market will always under-provide, and in the case of a public bad such as pollution, it will over-provide.

Non-convexities

Standard economic theory generally assumes that the marginal benefit and cost functions associated with increased pollution are well behaved- marginal benefits are decreasing, while marginal costs are increasing. Therefore, if a set of complete markets exists for clean water or pollution control, the market sends the correct signal about socially optimal level of pollution.

But for many physical systems the marginal benefit or cost curve need not be so well behaved. The costs of marginal damages, for instance, may initially increase with increased pollution but then may actually decrease or go to zero as the physical system is destroyed and there are no additional marginal costs as pollution continues to increase4. The system is destroyed; nmore pollution cannot make it any more dead. This is a nonconvexity, and implies that more than one optimal level of pollution may exist.

Asymmetric Information: Moral Hazard and Adverse Selection

Market failure due to asymmetric information can occur due to two reasons, when a person in a transaction does not have full information about either the actions or the “type” of the second person. The former is referred to as moral hazard, while the latter is known as adverse selection.

Moral hazard creates two problems for environmental assets. First, when the regulator cannot monitor actions, a person has an incentive to shirk on pollution abatement since he bears all of the costs and receives only a part of the benefit. Second, when a private market cannot monitor actions, an insurer might withdraw from or limit the pollution liability market. The market provides an inefficient allocation of risk.

Adverse selection is a problem in the market for eco-products. Here the basic problem is that these products may be of perceived higher quality and more ethically desirable to some consumers given the production process, but these very same reasons make these more expensive to produce considering the environment is not subsidizing its production. Unless there exists a very meticulous consumer watchdog groups, any seller may claim greater environmental friendliness and ask for a higher price; the buyer, however, has difficulty or faces too high a cost in determining whether this is actually the case.

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Other causes of inefficiency that causes market failure could be diverging private and social discount rates, which stem from a difference in private and social risk premiums. Political process are yet another source of inefficiency, more specifically rent seeking. Rent seeking is the use of resources in lobbying and others activities directed at securing protective legislation, which increases the net benefits going to a special interest group but frequently lowers the net benefits to society as a whole.

After examining most causes of inefficiency that lead to market failure, in the pursuit of efficiency, we we will now look at Ronald Coase’s conception of how private resolution through negotiation (most effective for a two-party case) and court legislations (in defining property and liability rules) could counter the effects of inefficiency.

Coase Theorem

Assume a world in which some producers or consumers are subject to externalities generated by other producers or consumers. Further, assume (1) everyone has perfect information, (2) consumers and producers are price-takers, 93) there is a costless court system for enforcing agreements, (4) producers maximize profits and consumers maximize utility, (5) there are no income or wealth effects, and (6) there are no transaction costs. In this case, the initial assignment of property rights regarding the externalities does not matter for efficiency. If any of these conditions does not hold, the initial assignment does matter.

With regards to court intervention to solve disputes on externalities, Coase theorem plays an important role is concluding that irrespective of initial assignment of property rights (with the mentioned initial conditions), efficient level of production results. The theorem shows that the very existence of an inefficiency triggers pressures for improvements. Also, Liability rules tend to correct inefficiencies by forcing those who cause damage to bear the cost of that damage.

Twin Market Failures

In the real world, multiple market failures may exist at the same time making the assessment of the contribution of each difficult. An example of twin market failure is that of environmental policy and diffusion of new technologies to address the environmental challenges. The externality of pollution is generally internalized through an environmental policy. However, setting an efficient environmental policy requires a comparison of the marginal costs and benefits associated with the reduction of pollution. With the introduction of new technologies, marginal costs and benefits of pollution reduction are liable to change typically lowering the marginal cost of pollution reduction.

If we convert the above environmental policy & technological innovation interaction to a dynamic one over time, choosing an efficient environment policy requires keeping in mind the fact that technology will over time lower the cost of pollution abatement. For costs to be lowered, innovation as well as adoption of technology must occur. Both, however, are characterized by externalities. Due to knowledge externalities, it is generally not profitable for a firm to invest in innovation. Too little of innovation is produced due to its positive externality. Further, the cost of new technology to a user may also depend on how many others users have adopted it. Generally, the more other people use the technology the lower will be its cost. Thus, there is an externality in adoption of technology as well.

Both innovation and diffusion of new technology are characterized by additional market failures related to incomplete information. Imperfect information about returns on investment in innovation encourages too little research and development. In the context of environmental problems such as climate change, the huge uncertainties surrounding the future impacts of climate change and thus the likely return on R&D exacerbates the problem. With respect to technology adoption, imperfect information about the impact of the technology can slow the diffusion of technology.

The fact that markets might underinvest in technology when dealing with the market failure relating to pollution control strengthens the case for making sure that environmental policy is designed to foster, rather than inhibit innovation. The twin market failures here are thus related: pollution represents a negative externality, and new technology generates positive externalities. Hence, in the absence of appropriate public policy new technology for pollution shall be doubly underprovided by markets.

Due to these twin market failures, there is a case for explicit technology policy to address environmental problems in relation to the environmental policy. There are several reasons why a mix of technology and environment policy might work better than mere environmental policy. Firstly, there are practical limitations of environment policy. Though most scientists would argue that the pricing greenhouse emissions is the most efficient method for addressing global climate change, most of the countries have largely put off significant environmental policy intervention. Hence, a policy directed at fostering greenhouse reducing technology may prove better policy. Secondly, policies directed at technology rather than environment is generally politically more feasible.

The governments can foster technology policy for environment by focusing on innovation and adoption policies.

Innovation Policies: The government could either use the demand or supply side measures to incentivize innovation. The demand side approach increases the return to developing such technologies. The supply side approach would involve making it less expensive for firms to undertake research in environment, or by performing the research in public institutions.

Adoption Policies: The most important problem associated with adoption is that of technology lock in. If the government encourages the diffusion of a particular technology, it is possible that it could become so entrenched that it might stifle the development of a superior technology. To avoid this, focus should be on making sure that specified environmental objectives are achieved without focusing on a particular technological approach. Technology diffusion could be encouraged by subsidies and tax credits. It can also be improved by encouraging information provision.

In conclusion, when dealing with twin market failures, normal approaches mentioned in the first two sections of this article may not work in entirety. There is a need to supplement the policies with non-market based interventions as well by identifying the linkages between the failures in environment and technology markets.

This section looks at the practical application of economic instruments with a focus on efficiency as well as social cost minimization. It is assumed that targets are set through a political process using scientific inputs on likely damages and economic inputs on both damage costs and control costs. There exists 2 types of targets – target reduction in emissions output (for example, target reduction of 10 mi tonnes of SO2 levels) and target improvement in ambient environment quality (for example, fixing upper limits for lead content in drinking water). Also, a source is a point of discharge of pollution, a receptor is a point at which the level of ambient pollution is measured and the transfer coefficient is the ratio of change in pollution at receptor to the change in emission at the source. Some ways to reduce emissions include reducing output, changing the production process, using end-of-pipe technologies etc.

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Taxes

An important principle used in taxation for uniform pollutants is the Baumol Oates Least Cost Tax theorem which states that:

“A tax rate set at a level that achieves the desired reduction in the total emission of pollutants will satisfy the necessary conditions for the minimization of the programme’s cost to society.”

The implications of this theorem are that: (a) the firm has no price-setting power in the input or pollution abatement markets, (b) least cost tax = Marginal abatement costs at the target level of emission, and (c) for a given tax, the marginal abatement costs across all firms must be equal under cost-minimising solution.

In the case of a non-uniform pollutant, a single tax is no longer efficient since the tax rate will vary across sources. The target here will be to reduce ambient concentrations to some target ambient level. To achieve an efficient solution, each firm must face a different tax t*k which is determined by that firm’s degradation of environmental quality at each monitoring point (given by transfer coefficient) and by the ambient target. Separate tax rates for each monitoring point which are adjusted for each firm according to its transfer coefficient relating to that point can be levied, the only disadvantage being that it is administratively and politically difficult. In such cases, zonal taxes are preferred. A zonal tax is levied region-wise wherein each region or river basin is divided into zones and within each zone, the same emission fees applies. Different zones have different fees. Zonal taxes provide flexibility but are difficult to administer. Too many zones may lead to an ambient system being set in place.

Other kind of taxes include input taxes that tax firms based on the inputs they utilize. The downside of input taxes is that there is possibility of substitution which, if it goes undetected, may eventually be more harmful on the environment. Product taxes are another option if a predictable relationship between output and emissions can be found but taxes will be dependent on when the product is used and how it is disposed.

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Problems with pollution taxes

It is important to consider several policy issues pertaining to pollution taxes. An initial incorrect tax rate can lock firms into incorrect investments in pollution control equipment. In such cases, costs are not minimised, as shown in Walker and Story (1977). A low initial rate may result in irreversible environmental damage. It is tricky getting the rate right due to the aggregate marginal abatement cost (MAC) function being unstable over time. This is caused by real-term fluctuations.

Another issue is that aggregate emissions increase with new entrants, as the aggregate MAC goes up. In the case of a basket of pollutants, regulating to set the correct taxes is a nightmare. An issue linked with equity is the undesirable redistributive effect pollution taxes have on households. Moreover, due to uncertainty over actions, the environmental target under a pollution tax regime is achieved only if: (a) all polluters are cost minimisers, (b) all producers are well-informed about their MAC schedules, and (c) no untaxed emissions are possible.

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[Fig.1] Comparative regulatory analysis

Consider the figure above. The Y-axis is the ‘total cost of control’ mapped on the X-axis’ ‘particulate concentration’. This is based on a study done in St. Louis by Atkinson and Tietenberg (1982). They compared the control costs for these three regulatory systems. However, a limitation is that they looked not at marginal damage but standard ambient levels.

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Permits:

Emission Permit System (EPS) applies for uniform pollutants. Firm A reduces emissions by 1 unit and sells this permit to firm B which can increase its emissions by 1 unit. Ambient Permit System (APS) applies for non-uniform mixing pollutants each source’s marginal abatement cost is equal to weighted average of shadow cost of emission reductions needed to achieve target.

When there are multiple sources and receptors, market equilibrium exists in buying and selling the ambient pollution permits for any initial issuance of permits. After trading has occurred, the number of permits held by various firms for polluting each receptor must be less than or equal to the number of permits initially issued for that receptor.

Pollutants can be classified based on the concept of time into stock (pollutant that accumulates over time), flow (pollutant that fades with time) and temporal variability. It is important that marginal damage must include the damage that is over the time period when pollutant is resident in the environment.

The marginal savings from emitting a unit of pollution today equals the sum of all the marginal damage that may occur in the future. This marginal damage is discounted by 2 factors – the discount factor and the persistence of pollutant.

Accumulation of pollutants also differs with respect to whether they are being emitted during the day or during night times, which season, and the accumulative capacity such as whether it is a windy space or still space. The damage differs depending on these above mentioned factors. The analysis is however, similar to that of space.

When multiple pollutants are considered, the case is no longer linear. Permits issued for a certain amount of acid deposition can be quite effective and they can be converted into emission rights based on the different transfer coefficients aij (here, the ratio of increased pollution of type j from increased emissions of compound i)

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Basic Debates

Some important design issues include whether firms should be allowed to ‘bank’ emission reduction credits and whether trade should be allowed between point and non-point sources of pollution. Banking emissions can be seen as a hedge against uncertainty and would be helpful in reducing pollution but may also imply that it may lead to an increase in pollution at some other point of time. Allowing trade between point and non-point sources of pollution may lead to a welfare gain but one must keep in mind that the marginal abatement cost for point sources is higher than that for non-point sources.

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Prices versus Quantities

In a situation wherein the government has complete knowledge about aggregate costs and benefits of reducing greenhouse gases and producers know their abatement costs, i.e., there exists perfect certainty, taxes and permits achieve exactly the same abatement at the same cost. In reality, the government knows less than the producers about costs and the producers have imperfect knowledge and hence no one can say with certainty whether a price instrument (tax) or a quantity instrument (permit) will achieve higher abatements. While a tax limits the marginal cost of abatement, it offers more economic certainty but offers no guarantee regarding the emission levels, a permit, by limiting total emissions, offers more environmental certainty but does not necessarily limit the marginal cost of abatement.

Weitzman discusses this very issue in his paper Price Vs. Quantities (1974). He concludes that when the marginal benefit of a curve is steep, quantity instruments such as permits are more effective, whereas when the marginal benefit curve is flat, a price instrument like the tax is preferred.

Taxes yield lower expected losses than permits and provide certainty regarding the quantity of money that would be spent. Taxes are also relatively easier to administer. But choosing a price instrument can be more disastrous than a quantity instrument as crossing a particular threshold, say for emissions, when a price instrument is in place can turn out to be a catastrophe. Quantity instruments, on the other hand, can prevent breaching of known threshold limits. It also helps in preventing under or overpaying. The disadvantage regarding quantity instruments is that they may lead to big price swings.

Consider a situation where a country must bring about an 83 percent reduction in greenhouse gas emissions (compared with 2005 levels) by 2050. It could adopt two different mechanisms: a quantity instrument such as cap-and trade or a price instrument such as a carbon tax. In a cap-and-trade mechanism, since the price of the permit is not known in advance, it creates uncertainty in the cost of compliance for firms whereas the use of emission taxes may lead to an environmental outcome that is not guaranteed. If a particular threshold is crossed, this would lead to horrific runaway green house gas effect. Using Weitzman’s result, one may conclude that, if the threshold is known, then a quantity instrument is best utilized whereas if it is not known and if the situation is not that risky, a price instrument is the option to choose.

Recently, hybrid models, such as a cap-and-trade system with a ‘safety valve’ are in vogue. These limit the maximum market price of emission permits, simultaneously mimicking the impact of an emission tax. Using an emission cap, combined with a tradeable permit system with the maximum price capped would help overcome fundamental disadvantages prevailing in both systems and permits flexibility.

Further examples of price and quantity controls being used in the field of renewable resources would be in Boston where quantity instruments have been introduced to ensure that 15% of electricity is obtained from renewable resources by 2020 whereas in Europe, price mechanism is being utilized to encourage the development of expensive solar power by guaranteeing high payments to producers of renewable energy.

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Implementing marketable permits

The relevant concerns linked with initial permit issuance include the possibility of a huge resource transfer from firms to the government. This can be avoided by means such as a zero revenue auction. The initial allocation is key, and it is possible to achieve the same effect as an efficient fee. Another problem is posed by the question of permits for new entrants, which a good design will accommodate.

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Problems with Tradable Pollution Permits (TPP)

[Fig.2] Monopsonist

The first major problem is market power. Consider the figure above, mapping Y-axis ‘total cost of control’ on to X-axis ‘particulate concentration’. Dominant firms (monopsonists) bring about a manipulated emission level rather than the efficient one. A correct initial allocation is necessary to attain proper emission levels. There are two kinds of manipulation that firms engage in – cost-minimising manipulation and exclusionary manipulation, the latter to disadvantage rivals in the product market. In cases of market thinness, equalizing marginal control costs across firms is hard, since transactions are infrequent and permit costs are high.

Taking up the problem of transaction costs: this negates the main benefits (trading permits and pricing them equal to the opportunity cost of emitting). Stavins (1995) lists three types of sources for such costs: (a) search and information costs, (b) bargaining and decision making costs, and (c) monitoring and enforcement costs. Foster and Hahn (1995) note that transaction costs work against small trades. Tietenberg (1990) gives examples of an offsetting scheme (1977) and a bubble scheme (1979), and the EU Emissions Trading System (ETS), contending that its competitiveness and rent-seeking is due to grandfathering, and noting that national non-compliance of member states is an issue.

Trading rules and non-uniform mixing poses another problem for TPP. Emission Permits System (EPS) must be played off versus Ambient Permits System (APS); while the latter are complicated, they are more appropriate for non-uniformly mixed pollutants. The rules for offsets are simple: the permits are in units of emissions, and their trade is governed to stop violation of ambient quality charges. There are three types: (a) pollution offset, in which trade must not violate ambient levels at receptor points, (b) non-degradation offset, with the additional condition that there should be no increase in emissions due to trade, and (c) modified pollution offset, which ensures that neither pre-trade nor target ambient levels are violated. Atkinson and Tietenberg (1987) used the cases of St. Louis and Cleveland to compare that the Least-cost solution (APS) versus the State Implementation Plan (command & control), which was exorbitantly expensive in comparison. There is, notably in this regard, also a sulphur trading case study that refers to the 1990 Clean Air Act Amendments in America.

Another problem is whether to favour grandfathering or auctions. While the former is politically feasible, it creates rents and runs the risk of moral hazard, with firms increasing emissions over cost-minimising levels in the run-up to reissue. An auction system can be designed in various ways, such as single price, but should preferably follow the incentive-compatible Groves mechanism, for instance using a Vickrey second-price auction adaptation. Another problem is that of sequential trading, for which Atkinson and Tietenberg have outlined four scenarios: (a) simultaneous, full information, no increase in total allowed, (b) sequential, full information, biggest cost-saving trade downward, (c) partial information, lowest cost firm is the first seller, and (d) partial information, randomly selected firm is the first seller. The penalty is greater for stricter targets in a static one-shot formulation, as opposed to a dynamic market process. The price formation process can be separated from finalising contracts, allowing for a bilateral sequential process, which has been shown to replicate the least-cost solution. Moreover, the role of strategic behaviour, cheating and market power must also be considered specifically in sequential trading.

Considering innovation and cost savings over time, the graphs are self-explanatory. Requate and Unold (2003) put forward that due to the likelihood of individual firms tending to be free riders, taxes work better than permits for innovation. The regulator’s anticipation of innovation and pre-commitment to change in policy is required.

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Uncertainty

Pizer (1999, 2002) notes that we have little experience with large emission cuts, do not know future technological options, nor the ‘do nothing’ level of emissions. Montero, on a different note, adds that there is uncertainty on the part of firms over whether the regulator will approve trade or not. When it comes to the use of economic instruments for pollution control, or rather the lack thereof, most of it can be attributed to policymakers being unaware of the potential, practical problems such as few TPP traders and lack of political acceptability, and also institutional problems, with cost effectiveness not necessarily being the primary objective, and also pertaining to the ethical implications of economic instruments. Ultimately, there is a trade-off between increased financial burdens on firms but reduced abatement cost for society, and to make this less of a departure from the status quo, partial grandfathered schemes may be used, though it must be noted that all sizable tradable permit systems implemented to date are grandfathered. Little surprise then that there is resistance to significant changes in pollution control policy. In the light of this, gradual introduction is essential.

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Why market policies fail to address basic environmental objectives

Ackerman and Gallagher contend that “the market is a reasonable policy tool but not a reasonable blueprint for society’s goals”, and outline five forms of failure, which are: (a) large irreversible damages must be prevented, (b) outcomes for the future are important ($1@5%pa = $%17,000 in 200 yrs and $2m in 300 yrs), (c) many environmental values are not commodities that can be priced, (d) volatile market prices can cause wasteful misallocation of resources (early ‘80s oil price and small cars, 1995 recycled paper and 1997 mills shutdown), and (e) “if it’s not broken, don’t fix it”. They conclude by saying that the market mechanism decentralizes information processing and decision making, allowing each firm to analyze and respond to the data that affects its operations, and with complex technical choices requiring site-specific information, broad standards allow firms to choose the most cost-effective way of meeting standards. Hence market based policy is important. But they qualify this by pointing out that other approaches must be re-legitimised to enable a broader dialogue about the full range of options for environmental policy.

Renewable resources are those for which there is a natural replenishment augmenting the flow at a non-negligible rate. A depletable resource is that for which the feedback loop is negligible so there is a risk of running out. The Depletion rate depends on the durability and reusability of a resource. The challenge that resource economists try to deal with here is that of sharing a depletable unrecyclable resource sustainably across generations, and to gradually make the transition to suitable renewable substitutes. The challenge is somewhat different in the case of renewable resources. For renewable, the challenge involves maintaining efficient sustainable flow so as not to overshoot the rate of natural replenishment.

There are two models that explain intertemporal allocation of finite resources: The Two period Model, which explains how resources are allocated between two periods according to the resource’s demand curve, and the N-Period Model, which explains the allocation over a large number of years. The former explains why more than half of the resources would be used in the first period. A variable called Marginal User Cost is used to measure the opportunity cost of production involving the particular resource today precluding the production of the same in the future. The N-period model is an extension of this same concept. It explains how the Marginal User Cost, together with Marginal Cost of Extraction, rises steadily with increasing scarcity of the resource, until the combined value of the two (Total Marginal Cost) reaches the highest price anyone is willing to pay for a unit. In cases where a renewable substitute is available, the Total Marginal Cost only rises up to the point where it equals the Marginal Cost of the substitute, at which point the society switches to the substitute. But this switch point could be prolonged by technological progress and exploration activities which bring down the extraction costs of the depletable resource.

Marginal User Cost is a useful concept as it helps account for the asset value of the resource, the value that the owner stands to gain by leaving the resource under the ground in conditions of rising prices. Thus a producer who maximizes the value of the resource would be interested in conserving it for the future. Hence, the conclusion that, ‘as long as private and social discount rates coincide, property rights are well defined and reliable information about future prices available, a producer who selfishly pursues maximum profits simultaneously provides maximum present value to society’(Tietenberg, 128)

Government interventions to conserve depletable resources have often taken the form of price controls. One only needs to look at the case of Natural Gas in the U.S to see how this could fail miserably. As a result of the price controls imposed, share of gases in the interstate markets fell and inefficient substitutes promoted. This is because producers were overproducing due to falling of Marginal User Cost (as higher future prices cannot be expected). Future consumers are also made worse-off as the supply only lasts till the Marginal Extraction Cost meets the level of price control. Thus the transition to renewable resource is hastened. Unfortunately, the loss to future consumers is much more than the marginal benefits to current consumers which makes it an all-round inefficient scenario.

To understand how organized private interests or cartelization affects the utilization of a resource, let us take the oil example. OPEC currently produces two-third’s of the world oil. Upon careful observation, it is possible to isolate factors that affect cartelization of a resource as:

Price Elasticity of Demand

Income Elasticity of Demand

The supply responsiveness of other producers

The compatibility of interests among members coming together to form the cartel

The last point is particularly important and is quite well illustrated in the OPEC example. At any point, an OPEC member can cheat the cartel and sell oil at a lower price stealing the market away from the others. But even other than that, OPEC members have reserves of different sizes. The incentives of Saudi Arabia (which holds 33% of OPEC’s reserves) would be to preserve the value of the reserves for a long time by not pricing it too high leading to the undercutting of demand for oil. In comparison, a country with smaller reserve would not be so bothered about preserving value for the future and would possibly stand for extracting as much as possible now. But the size of the reserves gives Saudi Arabia a greater say in price setting within the cartel.

Economics of Renewable Resources

The line dividing exhaustible resources and renewable resources is not clearly drawn. Just as exhaustible resources, in a sense, can be renewed through exploration and technology, renewable resources can be exhausted. They are naturally regenerated on a time frame that is relevant to human exploitation.

But unless the population has already been reduced to the point of the critical threshold, natural growth will replenish the loss of biomass due to the harvest within a relatively short period.

Renewable natural resources include those resources useful to human economies that exhibit growth, maintenance, and recovery from exploitation over an economic planning horizon. The economics of such resources has traditionally considered stocks of fish, forests, or freshwater, much like a banker would tally interest on cash deposits. From an economic point of view, the management of biomass, soil fertility or aquifer depth has been forced into a framework of discounted, marginal, zero profit valuation. Economic value has been discounted to account for a positive time preference. Only marginal value (that of the next unit) is considered relevant to market-based decisions and all economic profits (including a normal return to factor inputs) should be driven to zero to maximize the sum of consumer and producer surplus at a social optimum. This framework can aptly be described as dynamic optimization and expanded to include risk and uncertainty, a social (vs. private) rate of time preference, non-market values, and systems without bias toward equilibrium.

The principal economic question in the management of renewable natural resources has been: How much of a resource should be harvested during the present vs. future time periods? Time is typically considered over the horizon of a single representative manager or economic operation. For instance, in ocean fisheries the economic question has been how much to harvest this season and how much to leave in the sea as a source of future growth next season. To strike this balance, economists have used methods of dynamic optimization (i.e. the best allocation over time). A renewable resource problem is typically framed as a maximization of some single measure of net economic value over some future time horizon, subject to the natural dynamics of the harvested resource, an initial stock size, a target for the end of the planning horizon (or a limit in the case of an infinite-time horizon), a measure of time preference, and other relevant market, price, and technology constraints. Advances in the treatment of risk and uncertainty, measurement of social versus private time preference, capture of non-market amenities, and analysis of non-equilibrium behavior have further extended this paradigm of efficient allocation.

The model described here assumes the growth of natural stock as logistic. The natural stock can grow to the maximum limit(Xmin) subject to the carrying capacity of the eco system. But when the stock gets depleted below a critical minimum (Xmin),- the minimum viable population the renewable resource loses its regeneration ability and becomes extinct. When you consider the growth pattern, the growth follows a bell shaped pattern with the growth maximized at Xm , and at this point, the maximum sustainable yield occurs. If we harvest the renewable resource in such a way that we take MSY from the stock, it will regenerate itself and we can get MSY again in the next period, and so on.

Market, Free (Open) Access and Common Property Solutions

What is the difference between efficient allocation and competitive market allocation of renewable resources? A competitive sole owner is supposed to have well defined property rights. This will be at MR=MC, i.e. the static efficient sustainable yield. What could be the consequences when access to the resources is completely unrestricted? Free access resources generate two kinds of generalities. 1. A contemporaneous externality which is borne be current generation and it involves congestion due to over- commitment of resources to fishing. As a consequence, current fishermen earn a substantially lower rate of return on their effort

2. An inter-generational externality which is borne by the future generations.

When access to the renewable resource is fee, an incentive to expend effort by each fisherman beyond E­c reduces profit to the whole group as such. Every one imposes a burden on everyone else. At the efficient level, each individual receive a profit equal to its share of the scarcity rent. However, this rent serves a stimulus for new fishermen to enter, driving up costs and eliminating rent. Hence open access results in over – exploitation of resources.

A resource owner with exclusive property rights would balance the use value against the asset value of the resource (that is, would consider future flow of returns also). When the access of the resource is unrestricted, exclusivity is lost. It is then rational for the individual exploiter to ignore the asset value, as he can never appropriate it. The process will dissipate all the scarcity rent.

The condition under which the renewable resource will get extinct is the following

The effort is costless-effort is at Emax and goes to zero

Harvest levels are above the natural rate of regeneration

The risk of resource extinction is high if there is a critical minimum size of population (Xmin).

On the other hand, a common property resource is one that is owned by a defined group of people. But there can be free access for members of the group. But it is very likely that the group will have rules and norms to use, restricting the use that any one is allowed to make of the resource.

Economics of Non-renewable resources

Till now we have seen the optimal exploitation rate for a renewable resource. However, most of the resources used today are non-renewable, exhaustible. While we were concerned with the optimal rate of use of the resource in case of renewable resources, our concern in case of non-renewable resource is to find the optimal rate of depletion of the resource. It is important to understand the effects of different rates of exploitation. Since the resource will be exhausted at some point of time in the future, the important questions to be asked are

How long the resource is going to last

What should be the optimal price of the resource

What is the switch point

Does the backstop technology come in use in an efficient way

The optimal rate of depletion is given by Hotelling’s rule, named after Harold Hotelling. This rule states that the price of any resource in any time period ‘t’ is equal to the price in some initial period compounded at a given discount rate. Therefore the owner would be indifferent between extracting the resource now and extracting it afterwards in case the discounted value of the resource remains unchanged. This implies that the resources in the grounds are treated as capital assets. Till now, we have assumed that the extraction cost is zero. However, if we do introduce some positive extraction costs in our model, the optimal price of the resource in all time periods will change. The optimal price of the resource will now be given by the sum of the marginal extraction cost of the resource and the marginal user cost (also referred to as royalty or the resource rent which is the appreciation in the value of the resource that has not been extracted).

Our problem now, is to find a way to determine the initial optimal price as well as the time period in which the resource will be exhausted. For determining these two, we introduce the concept of the “price of the backstop technology”. Since the resource under consideration is an exhaustible one, the price of the resource is going to be higher as lesser and lesser quantities of it are available. In other words, the exhaustible resource will be supplied at a very high price. At some point of time, even though the resource may not have been fully exploited, the price of the resource may be so high, that some alternate technology or resource which was not economically viable earlier becomes viable. This particular point is referred to as the switch point.

Now, we have the optimal price path given by the Hotelling’s rule. We also have the price of the backstop technology. Therefore, we can work in a reverse direction and figure out the initial optimal price. The optimal price will “deplete the resource at a rate which smoothly permits the transition from the existing resource to a backstop resource”.

Effects of change in parameters

In this section we look at the effect on the rate of resource depletion and the original price of changes in the parameters we have used so far in our analysis. These parameters are the discount rate, the price of the backstop technology, the stock of the resource, the cost of extraction and the demand for the resource.

Parameter which undergoes change

Change in the parameter

Initial optimal price

Time period for which the resource is used

Mechanism

Discount

rate

Increases

Decreases

Decreases

Higher discount rate leads to more rapid exhaustion of the resource

Resources become more valuable in the present than in the future

Price of the backstop technology

Decreases

Decreases

Decreases

Since the backstop technology becomes cheaper, the switch point is reached earlier

Stock of the resource

Increases

Decreases

Increases

Increase in the stock through discoveries of new reserves or new extraction technologies pushes the price path outward and downward, thus lowering the initial optimal price

Cost of extraction of the resource

Decreases

Decreases

Decreases

Recall that( optimal price = extraction cost + marginal user cost)

Therefore, a decrease in the extraction cost leads to a decline in the initial price

Demand for the resource

Increases

Increases

Decreases

If demand increases, then the demand curve will shift outwards and consequently the price path of the resource will shift inwards (to the left).

Hence, price will increase and the resource will be depleted sooner

Monopoly and the rate of extraction

A common perception is that a monopolist in control of an exhaustible resource would deplete the resource at a rate higher than the optimal rate and hence the resource will be exhausted in a shorter time period. However, a very simple economic rationale for monopoly behavior dictates that the monopolist would restrict output and charge prices higher than those that would have prevailed under perfect competition. This implies that the initial optimal price will be higher in the case of monopolist. Also, since the price charged is higher, there will be a lower demand for the resource. Thus, the effect is to increase the life of the resource stock. Therefore, a monopolistic control over exhaustible resources tends to conserve the resource. The exact difference in the rate of exploitation (from a perfectly competitive scenario) however, can depend on the elasticity of the demand curve for the resource

Environmental resources impart a complex set of values to individuals and various benefits to society. Environment valuation is based on the assumption that individuals are willing to pay for environmental gains and conversely, are willing to accept compensation for environmental losses. Individuals demonstrate preferences, which, in turn, place values on environmental resources. Environmental economists have developed a number of market and non-market-based techniques, based on the preferences, to value the environment.

These preferences can be either revealed preferences or stated preferences.

(I) Revealed Preference Methods or Surrogate Market Methods

In the absence of clearly defined markets, the value of environmental resources can be derived from information acquired through surrogate markets. The most common markets used as surrogates when monetizing environmental resources are those for property and labour. The surrogate market methods discussed below are the Hedonic Price method and the Travel Cost method.

a.Hedonic Pricing Method

The Hedonic Price method is based on consumer theory, which seeks to explain the value of a commodity as a bundle of various characteristics. Market goods are often regarded as intermediate inputs into the production of more basic attributes that the individuals really demand. It is based on the more general land value approach which decomposes real estate prices into components attributable to different characteristics like pollution, accessibility, proximity to schools, shops, parks, etc. The method seeks to determine the increased WTP for improved local environmental quality, as reflected in housing prices in cleaner surroundings. It assumes a competitive housing market, and its demands on information and tools of statistical analysis are high.

Multiple regression analysis is used to identify how much of a property differential is due to a particular environmental difference between properties. It has been found through several studies that multiple regression analyses in such cases over estimate the benefits by 2 to 3 times. The problem here is that most households are not aware of the costs or benefits of an environmental attribute and hence don’t know it when they adjust their residential locations due to a particular attribute.

The presence of multicollinearity (a statistical phenomenon in which two or more independent variables in a multiple regression model are highly correlated).

Omitted variable bias (an independent variable that should be in the model is ignored).

b. Travel Cost Approach

The Travel Cost method is a method which attempts to deduce values from observed (i.e., revealed) behaviour. has been used to measure the value of an ecosystem used for recreational purposes, by surveying travellers on the economic costs they incur (time, out-of-pocket expenditures) when visiting the site from some distance away.

It determines the WTP for access to the recreational benefits provided by the site, as a function of variables like consumer income, price, and various socio-economic characteristics. The price is usually the sum of observed cost elements like a) entry price to the site; b) costs of traveling to the site; and c) foregone earnings or opportunity cost of time spent. The consumer surplus associated with the estimated demand curve provides a measure of the value of the recreational site in question. More sophisticated versions include comparisons across sites, where environmental quality is also included as a variable that affects demand.

The estimation of recreational benefits can be done through –

Continuous variable specifications where the number of visits to a site is the dependent variable and the household characteristics are the independent or explanatory variables.

Discrete variable specifications where the values are restricted to a predefined set and not all characteristics of a household are taken into account.

The issues that arise with Travel Cost approach are:

Value attached to time – Estimated betas and estimated variables are highly sensitive to time.

Truncation Bias – Estimated demand equation is based on data based on the household that visited the site while the households that did not visit the site are ignored.

Limited in application – Captures only direct recreational benefits, and only when there are measurable travel costs.

Difficult to separate the effects of different factors, eg. Landscape beauty and proximity to the ocean.

Does not measure non-use or intrinsic values, nor commercial values.

(II) Stated Preference Methods or Non Market Methods

Stated Preference Methods seek to measure individuals’ value for environmental goods directly, by asking them to state their preferences for the environment. Unlike Revealed Preference Methods, these are used mainly to determine non-use values of the environment such as existence value, altruistic value and bequest value since these values do not turn up in any related markets. The importance of existence values was placed in the spotlight by John Krutilla’s seminal work “Conservation Reconsidered” (1967). Krutilla pointed out that certain “grand scenic wonders” and “unique natural environments” might be valued even by those who did not directly benefit from them.

Economists have traditionally been wary of stated preference methods to derive non-use values since there is wide scope for misreporting. Also, theoretically, practically everyone can claim to derive non-use values from a given environmental good. In practice however, it has been shown that the application of rigorous standards can go a long way in ensuring accuracy. The two most important (and rigorous) of these methods is the Contingent Valuation Method (CVM) and Choice Experiments (CE).

a. Contingent Valuation Method (CVM)

Contingent Valuation Method (CVM) was first used by Davis (1963) in a study of deer hunters in Maine. The CVM method to ascertain non-use values first came into the public spotlight in a significant way with the Exxon Valdez disaster of 1989. The National Oceanic and Atmospheric Administration (NOAA) of the US constituted a panel with Nobel laureates Kenneth Arrow and Robert Solow to determine whether CVM was a reliable way to ascertain lost existence values in the accident. Using the recommendations of the panel and several others, the NOAA conditionally accepted CVM as reliable, subject to elaborate guidelines for its use. Eventually an out-of-court settlement of 1.5 billion dollars was reached but a state-of-the-art CVM study pegged lost existence values alone at 3 billion dollars (Carson et al., 1992).

Most CVM exercises can be split into five stages (Hanley, Shogren and White, 2001):

Setting up a hypothetical market: This step consists of “framing” the environmental good by describing what exactly is at stake (say the destruction of an endangered species of plant due to excessive use by forest-dwellers), deciding how it would be remedied (placing a ban or limits on its use), calculating the costs entailed (resettling the forest-dwellers, providing them with alternate livelihoods) and deciding how funds would be raised (through taxes, trust fund payments).

Obtaining bids: This involves conveying the previous information to the respondents, preferably through personal interviews, and eliciting their WTP/WTA. Other information collected includes socio-economic data of the respondent and some de-briefing information. WTP/WTA information can be obtained by asking an open-ended question (respondents are asked their maximum WTP) or by a referendum-type question where respondents either answer yes or no in response to a particular payment amount. Referendums are most common.

Estimating WTP: For open-ended responses calculating mean or median WTP is simple. For referendums the WTP has to be estimated since the respondent does not reveal her maximum amount only whether or not she is willing to pay a given amount. Several approaches may be used which are beyond the scope of this article.

Aggregating the data: The mean bid or bids for the sample population must be converted into a population total value figure. This involves deciding who counts in the study – the local population, regional, national etc. Secondly is choice of the time period over which benefits should be aggregated. Here we are confronted with the limitations of using current preferences to estimate future preferences and the equity implications of discounting.

Carrying out validity checks: Several tests are carried to ascertain the robustness of the WTP figure obtained such as scope tests (is the scope of environmental change accurate?), convergent validity (is the WTP comparable to figures obtained from other methods?), are protest rates too high (those against putting a monetary value on the environmental good in question) etc.

Portney (1994) lists seven stringent guidelines issued by the NOAA (National Oceanic and Atmospheric Administration) to ensure that CVM is not misused to make offenders pay much than is fair. Some proponents of CVM were unhappy with this saying it would more often than not lead to an “underestimation” of lost existence values. Opponents of CVM claimed that CVM was altogether too arbitrary a method to give any reasonable estimate regardless of guidelines. Nevertheless CVM has become the most widely used estimate for non-use values of environmental goods owing to its simplicity, flexibility and cost-effectiveness.

The various issues that arise with the CVM method are:

Hypothetical Bias – Difference in actual willingness to pay and willingness to pay revealed in a survey arising from the fact that in actual markets purchasers suffer real costs, while in surveys they do not.

Information Bias – Distorted evaluation of information.

Strategic Bias – Causes survey results to differ from actual willingness to pay because individual have an incentive to not reveal the truth because they can secure a benefit in excess of the costs they have to pay. This arises from the free rider problem.

In a choice experiment, individuals are given a hypothetical setting and asked to choose their preferred alternative among several alternatives in a choice set, and they are usually asked to perform a sequence of such choices. Each alternative is described by a number of attributes or characteristics. A monetary value is included as one of the attributes, along with other attributes of importance, when describing the profile of the alternative presented. Thus, when individuals make their choice, they implicitly make trade-offs between the levels of the attributes in the different alternatives presented in a choice set. This enables the researcher to derive the value of each of the different attributes of a particular alternative (Alpizar, Carlsson and Martinsson, 2001). CE involves considerable effort in the design of relevant scenarios with appropriate attributes and in the use of statistical methods.

Using CE, the WTP for specific “attributes” of the proposed environmental change or alternative can be derived. This disaggregation allows for the possibility of compensating the some attributes of the situational change in kind and others monetarily (Adamowicz et al., 2005). CE also enables much greater accuracy in framing the final alternative.

There are three important advantages that CE has over CVM (Alpizar, Carlsson and Martinsson, 2001): (i) reduction in some of the potential biases of CVM (ii) more information is elicited from the respondent compared to CVM and (iii) the potential of testing for internal consistency. The only major disadvantage of CE is that is it far more complex and expensive to administer compared to CVM.

(III) Other methods

Dose Response based Valuation

This is an indirect procedure of valuating environmental costs and benefits. Dose Response method analysis the relationship between say, pollution and an effect it has, for instance, health effects. It is the process of characterizing the relationship between the dose of an agent administered, and the occurrence of an adverse health effect amongst the exposed. The incidence of the effect is then estimated as a function of human exposure to the agent. ‘Dose’ indicates the amount of the agent while ‘response’ refers to the effect of the agent once administered. Dose-response relationships are determined graphically by determining the effect of varying the administered dose on the response. Generally, increasing the dose of a harmful agent will result in a proportional increase in both the incidence of an adverse effect as well as the severity of the effect. Dose Response method is usually administered when the exposed population is unaware of the effects of pollution because it is not direct; it is also employed in developing countries where there is lack of data for such valuation methods.

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Benefits Transfer

As valuation exercises are costly, researchers need some means of estimating non-market benefits without always having to undertake an individual study. Benefits Transfer is looked at as a way to make environmental valuation a standardized component of environmental Cost Benefit Analysis for policy making and environmental management. Benefits Transfer mainly works by taking estimates from one or more original studies, and transferring the results to a new context by adjusting for two factors: (a) differing socio-economic characteristics of beneficiaries, and (b) differing environmental characteristics of the two different contexts. There are two main approaches to benefit transfers:

Usually, a meta-analysis (a statistical analysis of past valuation studies) is carried out. The transfer error is usually between 20-40% for the first method (absolute transfer error) and can go up to 228% for the second method (benefit function transfer error).

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Conclusion

Environmental valuation techniques are primarily driven by the principle that individuals are self-interested and demonstrate preferences that form the basis of market interactions. Existence values are not demonstrated in the marketplace and are at least somewhat based on unselfish motives making them problematic to environmental analysts. To quantify existence values accurately within the framework of environmental valuation is difficult; for example revealed preference methods, such as the travel cost method and hedonic pricing methods, measure the demand for the environmental resource by measuring the demand for associated market goods. Existence values are not adequately captured using these methods. Existence values are best revealed through surveys of individual willingness to pay for the environmental resource or willingness to accept compensation for environmental losses.